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FOREX RISK MANAGEMENT

Presented by

forex-Capital Services Pvt. Ltd.
Forex Portfolio Managers & Advisors

OBJECTIVES BEHIND FOREX MANAGEMENT
      COST REDUCTION CONTAIN LOSSES OPTIMISING EXCHANGE GAIN PROTECT OPERATING PROFIT ACHIEVE BUDGETS AND TARGETS INSURE AGAINST ADVERSE EXCHANGE RATE MOVEMENTS

HOW TO ACHIEVE THESE OBJECTIVES?
 Determine the nature of exposure  Evaluate the risks and rewards  Decide targets & strategies to safeguard against currency risk  Formulate policies for day-to-day operations  Strong MIS Reporting system  Periodical review of performance & strategy  Single treasury concept for forex & money market

KEY FACTORS FOR AN EFFECTIVE STRATEGY
• Management’s attitude towards risk • Type of exposure – Tenure & Cost • Firm’s willingness to devote the amount and quality of resource to exposure management function • Access to various markets & instruments such as forwards, options, futures etc and there implications • Choice of currency - Dollar / Non- Dollar • Gross or Net Exposure to be managed

NATURE OF RISK
CURRENCY RISK
- Dollar

vs. INR - a) Spot b) Forward - Cross Currency - DUAL Exposure

INTEREST RATE RISK
Domestic & International

OTHER ECONOMIC RISK
- Competitor’s pricing strategy - Fluctuations in price of raw material - Policy changes

FACTORS AFFECTING RISK
Economic - Domestic & International Political / Country Risk Regulatory Spillover Other untoward events

IDENTIFYING RISKS
Strong information system for Currency exposure Continuous flow of information, review of factors affecting risk Continuous process involving reading, interaction, experience etc. Prediction extremely difficult

MANAGEMENT’S APPROACH TOWARDS FX-MANAGEMENT
 CONSERVATIVE APPROACH
      Hedge the exposure as it arises Yields and costs of transactions are known Less risk of cash flow destabilization Less of management time and effort required Unlikely to yield optimum results Any opportunity arising in the market cannot be encashed

 MODERATE APPROACH
    Partial/Selective hedging Scope for taking advantage of opportunity gains Helps in averaging out total cost Management time and effort required

 AGGRESSIVE APPROACH
      Active trading in currency Continuous cancellation and rebooking Aim is to treat treasury as a separate profit center Active treasury and management efforts must High Risk :High Reward scenario Proper evaluation of risk extremely important bearing in mind risk-taking appetite of the company.

 INDIFFERENT APPROACH
     No conscious decision to manage exposure No hedging - everything left to chance Risk of destabilization of cash flows very high Merit – ZERO investment of time and effort Worst approach – Highly speculative

EXCHANGE RATE AND OPERATING EXPOSURE
• Changes in revenues, costs, cash-flows and profits • Effects competitiveness of the firm, attractiveness of various markets, relative cost of sourcing inputs • Information required on output market structure, competitor’s cost structure, their likely response to exchange rate changes, own cost structure • Participation of personnel across various functions like marketing, purchase, production and finance

TOOLS FOR HEDGING CURRENCY EXPOSURE
 FINANCIAL ENGINEERING PRODUCTS –
Forwards, Options, Swaps, Futures, FRA’s Exotic structured products etc

 INTERNAL HEDGING STRATEGIES • NETTING – receivables/payables can be netted out by
• • • •

matching amount. It reduces the amount of exposure to be covered hence reducing the banking costs LEADING & LAGGING – shift the timing of exposures by leading or lagging payables or receivables INVOICING – choice of currency for invoicing ASSET & LIABILITY MANAGEMENT – for e.g increase exposed cash inflows in stronger currencies and vice-versa PRICE VARIATION

FINANCIAL ENGINEERING PRODUCTS
Forwards, Futures, Options, Swaps Some Myths
• • • • • Complex pricing Greater loss due to complexities Difficult to manage Upfront Premia – Mental Block Zero Cost Options!! – Is there any free lunch anywhere??

Choosing the right product
• Usage depends on market perception and individual requirement.

OPTIONS
A contract between two parties which gives them the right but not the obligation to buy/sell at an agreed price at a future date
– – – – – – – Call Option: Right to buy Put Option: Right to sell Exercise price: Set price between two parties Option premium: The price buyer pays to the seller. Loss potential: Limited to premium. Downside risks protected, upside gains unlimited. Profit potential: Limited or unlimited depending on the strategy.

Options are best bet if markets are volatile and risks are asymmetric.

SWAPS
• Swap is an agreement between two parties to exchange
their liability (Interest, Principal) • Interest rate swap exchange of periodic interest payments (No exchange of principal). Eg. from fixed rate of interest to floating rate and vice versa. • Currency Swap exchange of interest and principal in two different currencies.

USAGE
• Asset/Liability management • Issuing or reducing the burden of debt
(Please see our FOREX EDUCATION section for detailed understanding of Derivative Products)

RISK/REWARD
Risk/Reward profile of parties in Interest rate swap
Interest Rate Decreases Floating rate payer Fixed rate payer Gain Loss Interest Rate Increases Loss Gain

3F’s OF THE FX MARKET
• FORWARDS – contract to sell/buy specific amount of currency at a future date against expected receivables/payables at a predetermined rate • FORWARD RATE AGREEMENT (FRA) This is interest rate agreement for future dates between two parties on LIBOR/LIBID • FUTURES - simultaneous right and obligation to buy/sell a standard quantity of a specific financial instrument at a specified future date and at a price agreed between parties at the time of contract.

FORWARDS & FUTURES
Forwards
OTC contracts

Futures
Exchange traded contracts

Tailored contracts
Settlement at maturity Credit approval and lines required

Standardized contracts
Daily cash settlement Margin cost involved

Bid/Offer spread may vary with customer
Low commission bid/offer spread on FRAs. Low commission but variable bid/offer spread on forex forwards.

Equal access regardless of size
Low commission cost and narrow bid/offer spread on Eurodollar futures. Relatively high commission but narrow bid/offer spread of forex futures.

OPERATIONAL STRATEGY
Setting optimum target rate Protecting benchmark rate Strong management information system Minimizing exchange risk While hedging protect operational profit Reducing interest burden Implementing sales policy on cost basis Minimizing foreign currency loan liability Trading positions Safeguard Operating Profit & Target Stop Loss / Take Profit Limit Lead & Lag Policy Continuous In & Out Options Review bench rate as per market trend

RECOMMENDING A STRATEGY
 Strategy for Current account Prevailing market conditions Market perceptions/views Safeguarding operating profit Quantify Expectations Choice of currency, Quantum of cover
Quantify and analyse cost of exposure with projection And actual

 Strategy for Capital account Tenure and costs involved Currency of Cash flow Reducing cost of interest Analyzing debt v/s cost and return

FEATURES OF MIS REPORTS
          Streamline information Quick glance at current position Tool for day-to-day monitoring Summary for top management Strong back office & reporting system Cost benefit analysis Clinical precision in interpretation of data Identifying exchange risk Monitoring P&L of treasury Evaluation of performance

ADVANTAGES OF INTEGRATED TREASURY MANAGEMENT
• • • • • • Reduces cost of domestic funds and forex Competitive cost advantage Optimum opportunity gains Asset/Liability management Easy availability of funds An edge over others

REGULATORY IMPLICATIONS
 Regulatory implications are controlled mainly by four agencies:  MoF: Formulates the policies and directives.  RBI:  ECD: Based on govt. policies, issues instructions and notifications.  IECD: Manages export import credit regulations.  FEDAI:Association of bankers which implements & decides operational procedures on the basis of RBI directions.  Banks & Institutions: Based on overall directives as above under liberalized scenario decides their own policies and guidelines.

SUGGESTIONS & RECOMMENDATIONS
Hedging & Trading positions should be separately identified Firm decision should be taken on cost base Long-term & short-term views should be taken separately based on long & short term trend Need base hedging policy should be adopted, instead of market driven sentiment

Trading & hedging policy should be clearly identified An approved Forex policy should be formulated A core committee for periodical review Set up strong back office and reporting system Set up treasury as a separate profit center

THANK YOU FOR SITTING THROUGH THIS PRESENTATION
For any further queries please contact

forex -Capital Services (P) Ltd.
S – 472, Greater Kailash - II New Delhi –110048 Tel: 011-51513202 / 51637735 Fax: 011-51637739 Email: contactus@forexcap.com www.forexcap.com